Caveat Entrepreneur

Beware the Faustian deal, dear entrepreneur, and choose your financial partners well. The marriage between you and your VC partner is not " 'til death do us part"

by Dave Lim.This is one of a series of articles published by CNET that I wrote while I was living in Silicon Valley during the first Internet Revolution in the late 1990s.

Dear entrepreneur,

As children, our parents and elders would often caution us against naively or foolishly giving our hard-earned money to others, especially if we do not know them well.

It would, however, been quite an uncommon experience had they had sat you down instead, and dispensed a long lecture on how to be very careful when receiving money from others. Well, it turns out that as an entrepreneur, who you take money from is as important as who you give money to.

GETTING MONEY FROM VENTURE CAPITALISTS (VCs) First of all, let me lay to rest a couple of major myths about VCs:

1) A VC is not some compassionate benefactor to turn to in your financial plight after all the bankers you've spoken to wouldn't give you a loan.

2) Neither is a VC is a benevolent philanthropist who will without much hesitation would fund the next "miracle cure for cancer that may save billions of lives", or for that matter, give you money for your idea for "the next hula hoop" that's you're convinced will sell millions around the world.

3) A VC is not just looking to only finance dropout PhD students or eccentric inventors locked away in the bowels of their basements or garages. This is the typical Hollywood stereotype, and a favorite and recurrent Disney them, and thanks to them we now have two Flubber movies!. Frankly, a VC would much rather invest in a team of professional engineers and well-dressed, business and market-savvy executives who have spent years working in a big company together and have decided to leave to pursue an opportunity they're encountered while at work. Less boring no doubt, and not the least bit romantic, but with much better prospects of success.

WHAT IS A VENTURE CAPITALIST? If you read twenty books on venture capital, you'll probably get twenty different definitions of what a VC is. Nonetheless, at the end of the day, a VC is fundamentally a professional money manager who invests money entrusted to him or her by investors. In return for services rendered, a VC takes a nice cut of the profits. And in the VC business, as it is in the fund management industry, the name of the game is Risk, Return and Diversification.

1. On RISK When you ask any professional investor or fund manager about risk, they will explain to you that on the lowest end of their risk spectrum, you have a "risk-free" rate which is a nice, safe government bond that gives you a safe, but low, return on your money. Money stashed under or in your mattress does not rank above a government bond because the risk that your house may burn down is higher than the risk of the government collapsing and defaulting on their debt. Further up the risk ladder are quasi-government, or state bonds, followed by mortgage backed securities, and so on as the credit risk get worse. On the uppermost rungs, are "blue chip" stocks of well-established companies, followed by smaller (and riskier) company stocks.

A VC's perspective on risk is no different, except that in terms of risk of any startup company, it's probably way off the risk ladder, and hopefully its prospects are held up by more than air, hot or otherwise.

2. THE RISK-RETURN TRADE-OFF This oft-quoted financial expression simply means "If you want me to take more risk, I better get a higher return on my money". Let's say you are an investor and you decide to give money to a Silicon Valley venture capitalist. The VC then invests your money in a startup with a prospective return of 100% over three years. Across the continent on Wall Street, the technology revolution expected to push the NASDAQ's yield to 20% for the next 3 years (equivalent to a 73% return over 3 years). Obviously your startup is expected to return much more than a listed high-tech company, but that it does necessarily mean it is a more attractive investment. It may not make sense to put your money for an additional 27% if you have to take a LOT more risk. So your VC had better invest in a startup which will give you a LOT more potential return, say 400% to 500% over 3 years.

3. THE VC's BOTTOM LINE So, the whole objective of a venture capital fund is to invest in thestock of a young company for a little as possible (buy low) as sell it for a much as possible (sell high), while holding the stock for a little time as possible (fast). This can be neatly summarized by three letters - the R.O.I. (Return on investment), the VC's bottom line.

When you are making your business pitch to VCs, you have to ask yourself "What's my startup's potential return?" Well, you say, who really knows? One thing's for sure, for a startup, it's probably as potential as potential can get. However, you think "I have such a wonderful product - I'm sure my company will be very successful!" But you can be equally sure that ROI is the foremost question on the VC's mind. As a professional investor, his job is to get a handle of yourstartup's potential return versus the risks of investing in you and your company. And remember, only seven out of a thousand business plans get to the IPO stage. So the risks are all too real.

However, what makes the VC game so exciting is to discover and invest in one of those seven companies because the returns can be beyond spectacular. Imagine if you had given money to Harvard dropout, William Gates III, for him to start Microsoft. Potential jackpots are what VCs are always on the lookout for. Be realistic however. The next Microsoft, CISCO, or Creative does not come along very often. No matter how much faith you have in the (obvious) spectacular-ness ofyour product or service, and the overwhelming enthusiasm with which youjust know that customers will have for your product when you launch it, that the exponentially rising sales forecast you've plotted on your PowerPoint chart is probably NOT going to materialize. Back up your projections with a realistic assumptions, or if you really DO have the "next Microsoft", back up your claim. Most VCs would agree that visionary entrepreneurs always have B.H.A.G. (Big Hairy Audacious Goals), but by the same token, that's not an excuse to suffer from delusions of grandeur.

DO YOUR HOMEWORK! Any VC worth his or her salt and Ivy League MBA does the necessary homework and checks out your 'story', your company's or product's prospects, the capability of your management team, and your integrity before investing any money – Well, wouldn't you do the same if a complete stranger you met three weeks ago asked you for 5 million dollars? In VC-speak, this is a called "due diligence".

As an entrepreneur, you should do no less when looking for VC funds. First of all, realize that not all VCs are alike – Some do not invest in hardware. Some only invest in startups which need more than 5 million. Some do not invest in internet companies at all.

Most VCs list their portfolio companies on their websites, so you can do your homework before you step into their presentation rooms. Say you research the VCs thoroughly, make your pitch, and the VC says he really likes your business concept. They may still not give you money. Perhaps they have already invested in a company in the same industry and are looking to diversify their risk, yet another critical investment factor. So even if your startup's business and financial prospects are sound, your startup may not fit in to their overall investment portfolio. Sometimes, VCs decisions can even be quirky. Some VCs onlyinvest in companies within an hour's drive from their office.

VCs do not even invest in early startups. When Steve Jobs and Steve Wozniak made their rounds among Silicon Valley VCs to finance their Apple computer, they didn't get a single dollar from any VC. Steve Jobs said one VC called him a "renegade from the human race" and had his secretary check their briefcases as they were leaving his office, just to make sure they didn't snitch any magazines from the waiting room. A large number of highly successful Silicon Valley companieswere never financed by VCs at all, so if you don't get VC money, it does not mean that you can't make it.

"ENTREPRENEUR BEWARE" In the investment circles, the classic counsel is "caveat emptor" (Let the buyer beware). This Latin phrase means that the risk you have chosen to take is ultimately yours and yours alone. If you had acted on your broker's recommendation to buy a stock, and if subsequently the stock plunges, you should not cry foul for the decision to buy was ultimately yours and yours alone.

Likewise, if you are an entrepreneur seeking financing from venture capitalists, your rule-of-thumb should be "caveat entrepreneur" .

Get to know as much as possible about the VC from whom you intend to seek funding. After all, it's never, "Goodbye, and thanks for all the millions. See you next time at the IPO!" Remember that once you take that cheque, the VC become no less than the co-owners of your business (and your lifetime dreams). Expect them to want a seat on your board of directors. Expect them to voice a different opinion about what should be the best way to execute your business strategy, or how to structure your company. Expect them to tell you to fire your Vice President of Marketing because they think he's not up-to-the-job and should be replaced immediately - even if the VP happens to be your brother. And if you later decide to give stock options as incentives for your senior management, they're probably say, "You'll have to take it out of your share of the company. We agreed that we'll have 40% post-money and that's not open to re-negotiation."

Beware the Faustian deal, dear entrepreneur, and choose your financial partners well. The marriage between you and your VC partner is not " 'til death do us part", but "'til IPO do us part", and it is most certainly for "richer than poorer".

As mom always says, "no relationship is made in heaven" and that applies equally well, when Angels give you money